How Portfolio Yield is Reset in Bond Mutual Funds
We all know that interest rates are bound to rise, the reversal of the interest rate cycle is only a matter of time. Since interest rates and bond prices move in opposite directions, as long as interest rates go up, bond fund returns will not be good. Another common practice is to look at the YTM portfolio (yield to maturity, the level of bond accumulation in the portfolio) and take it as an indicator of the expected return of a debt fund. Now let’s put it all together.
Rate of climb
When interest rates rise in 2022, the YTM portfolio of debt funds will grow. So when will the benefits of higher yields (interest rates) in the market flow to investors? Herein lies the relevance of the debt fund portfolio reset.
The coupon rate of a bond is a constant and does not depend on fluctuations in market interest rates. If the face value and issue price of a bond is Rs 100 and the coupon rate (interest rate) is 5%, the interest payment is Rs 5, unconditional. Also assume that the YTM-weighted average of all bonds in a debt fund’s portfolio is 5%. Thereafter, market interest rates increase and the YTM for daily NAV valuation increases to 6%. The relevance of this is that the price of the bonds for the daily calculation of the net asset value will be taken as that corresponding to 6%, which will be lower than the nominal value, since the yield and the price move in opposite directions. But, since the accumulation of coupons in the portfolio of the fund occurs at 5% and not at 6%, how to reconcile this?
Portfolio maturity matters
Over a period of time, as the instruments in the portfolio mature, the face value returns and the portfolio benefits. How? ‘Or’ What? Let’s say that for the bond with a face value of Rs 100 which was valued at Rs 99 due to the rise in yields, at maturity the portfolio benefits from Re 1, insofar as it holds the portfolio.
So the whole question is how long is the cycle for the entire portfolio of bonds or other instruments to mature? The indication for this is the maturity of the fund’s portfolio, which is the weighted average of all the instruments in the portfolio, which we can refer to in the fund’s fact sheet. Although technically the maturity of the portfolio is subject to change due to maturities and the purchase of new instruments, we have the indication. In a liquid fund, if the maturity of the portfolio is say 1 month, in about a month the portfolio resets. In a longer-dated fund, it takes much longer, while the negative impact of rising yields is greater.
When interest rates rise, funds with shorter durations like Liquid, Ultra Short, Low Duration, etc. will gradually benefit from it in 2022. Do not give high hopes; interest rates are currently falling, but gradually the level of accumulation of debt funds will normalize, that is to say, it will go from very low levels to reasonable levels. So, if your investment horizon is not very long, go for shorter portfolio maturity funds because interest rate reset happens faster here.
The writer is a corporate trainer and author
February 12, 2022